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Auction Basics: Background for Assessing Proposed Treasury Purchases of Mortgage-Backed Securities

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Auction Basics: Background for Assessing Proposed Treasury Purchases of Mortgage-Backed Securities Order Code RL34707 Auction Basics: Background for Assessing Proposed Treasury Purchases of Mortgage- Backed Securities October 14, 2008 D. Andrew Austin Analyst in Economic Policy Government and Finance Division Auction Basics: Background for Assessing Proposed Treasury Purchases of Mortgage-Backed Securities Summary To address the turmoil in financial markets, the Emergency Economic Stabilization Act (EESA; H.R. 1424, P.L. 110-343), enacted on October 3, 2008, authorizes purchases of “troubled assets.” The act passed the Senate on October 1, 2008, passed the House on October 3, 2008, and was signed into law the same day. The Administration proposed using reverse Dutch auctions to purchase troubled assets — primarily mortgage-related securities from financial institutions. In reverse Dutch auctions, a buyer purchases multiple objects from private parties at a price set by the last accepted bid. The government has used reverse auctions since the Revolutionary War. Designing efficient reverse Dutch auctions may present some tradeoffs between enhancing competition among bidders and overpaying for assets relative to their quality. Careful auction design, however, can help minimize these problems. Auctions are especially useful for selling assets whose value to potential owners is unknown to the seller. Reverse auctions are useful when a buyer does not know what value sellers place on assets. Auction results could clarify the market value of troubled assets. The price discovery properties of auctions could stimulate trading by reducing private traders’ uncertainty about the value of troubled assets. A reverse auction program essentially swaps Treasury securities for troubled mortgage-backed securities. If Treasury securities are exchanged for troubled assets at prices close to those assets’ current market prices, costs to the taxpayer would be minimized. Financial institutions, however, may gain some liquidity, but might not receive much additional capital. Some economists have argued that other means of injecting capital into the financial sector, such as purchases of preferred stock or capital injections balanced by equity warrants (i.e., options to claim an equity stake), might be a better strategy. Since passage of EESA, the U.S. Treasury has been working to design methods to inject capital into firms and restore market liquidity. The heterogeneity of troubled assets may present challenges to the Treasury auction program. The reverse Dutch auctions would need to be adapted to buy highly diverse and relatively small-volume securities, in a way that minimizes risks of trading manipulation. Reverse Dutch auctions may be vulnerable to adverse selection, meaning that the average credit quality of submitted assets of a given type may be systematically worse than the average credit quality of all assets of that type. Auction mechanisms might be designed that could mitigate these problems. Recent academic research in auction theory and in experimental economics has examined how various types of auctions work. Auctions may capture higher revenues for governments and can often allocate scarce resources more efficiently than traditional methods of selling or purchasing. Different policy problems, however, call for different types of auctions. Government economists involved in designing reverse auctions to buy troubled assets have drawn upon academic research and internal Treasury research. This report will be updated as events warrant. Contents Dutch Auctions and Reverse Dutch Auctions............................2 Quality Differences of Troubled Assets Presents Challenges for Auctions . 4 Adverse Selection and Firms’ Asset Holdings ...................6 Reputational Issues and Participation ..........................7 Sequencing Issues .............................................7 Will Auctions Unlock Credit Markets? .............................8 Costs and Risks to Taxpayers ...................................10 Auction Design ..................................................10 Single-Unit Auctions..........................................10 Why Are Treasury Auctions Called Dutch Auctions?.............11 Imperfect Information: Common Values and the Winner’s Curse ...11 Revenue Equivalence......................................12 Multiple-Unit Auctions ........................................13 Manipulation and Demand-Reduction Strategies ................13 Complementarities ........................................13 Dutch Auctions with Multiple Units ..........................13 Uniform-Price vs. Individual Price Auctions....................14 Auction Basics: Background for Assessing Treasury Purchases of Mortgage- Backed Securities To address the turmoil in financial markets, Congress passed and the President signed the Emergency Economic Stabilization Act (EESA; H.R. 1424, P.L. 110-343) on October 3, 2008. The act authorizes the Secretary of Treasury “to restore liquidity and stability to the financial system of the United States” (Sec. 2) by purchasing or insuring “troubled assets.” The Secretary will design the mechanism for purchasing the troubled assets and methods for pricing and valuing these assets. The act broadly defines troubled assets as (1) mortgages and any securities based on such mortgages whose purchase the Secretary determines will promote financial market stability, and (2) any other financial instrument whose purchase the Secretary and the Federal Reserve Board Chairman determines will promote financial market stability. The act authorizes Secretary Paulson to use $700 billion to enhance liquidity and to inject capital into financial markets by purchasing (1) mortgages and pools of mortgages, (2) preferred stock in ailing financial institutions, and (3) troubled mortgage-backed securities (MBSs).1 The Secretary has indicated that reverse auctions will be used to purchase mortgage-backed securities from troubled financial institutions. A well-designed auction could help determine the price and value of these assets in an efficient manner. The act establishes a Congressional Oversight Panel to review the current state of financial markets, the regulatory system, and the administration of the Troubled Asset Relief Program (TARP) by the Secretary. This report provides Congress with information on the uses, design, and functions of auctions. It reviews some common types of auctions used by the federal government and some of the complexities of auction design that the Secretary will have to deal with in the TARP. 1 MBSs are debt obligations representing claims to the cash flows (principal and interest) from pools of mortgages primarily on residential property. The main use of MBSs is to transform relatively illiquid financial assets (mortgages owned by mortgage originators) into liquid and tradable capital market instruments. Given the problems with the housing market and subprime mortgages, it is difficult to know the true value of MBSs. Consequently, MBSs have become illiquid. CRS-2 Dutch Auctions and Reverse Dutch Auctions The Administration has proposed using reverse auctions to purchase mortgage- related securities from financial institutions, which are similar to the multiple-unit Dutch auctions that the Treasury uses to sell government securities. In a reverse auction, a buyer accepts bids from multiple potential sellers. In reverse multi-unit Dutch auctions, a buyer (e.g., the U.S. Treasury) buys a given number of units from private parties (e.g., financial institutions) at a price set by the last accepted bid.2 Figure 1 below contains a hypothetical example of a reverse Dutch auction. Auctions provide a means of selling objects whose value to potential owners is unknown to the seller. Many different auction mechanisms are in common use. A large research literature in economic theory and experimental economics examines how different types of auctions work. On the one hand, well-designed auctions can provide an expeditious and efficient method for selling or acquiring objects. On the other hand, poorly designed auctions have caused governments to forego large amounts of revenue. Moreover, poorly designed auctions may increase the likelihood that valuable resources are allocated to buyers who value those resources less than others — a source of inefficiency.3 In particular, auctions suitable for some applications may be unsuited for other applications. The American government has used reverse auctions since Robert Morris, who headed the Treasury Department, used them to procure supplies for troops in the Revolutionary War.4 In recent decades, the Treasury Department has used auctions to sell federal securities.5 Over time, the federal government has gained valuable experience in conducting and designing auctions, which has reduced costs and increased revenues compared to other methods. 2 Dutch auctions usually refer to falling-price auctions, which are described in more detail below. The reverse multi-unit sealed-bid auction outlined by the Treasury is strategically equivalent to a certain falling-price multi-unit auction, which is why the former is usually called a Dutch auction. 3 Paul Klemperer, “Using and Abusing Economic Theory — Lessons from Auction Design,” Journal of the European Economic Association, 2003, available at [http://www.paulklemperer.org/]. In some situations, auction designers may face a tradeoff between maximizing expected seller revenue and maximizing the likelihood that resources are allocated to those who value them the most. 4 Robert E. Wright, One Nation Under Debt: Hamilton, Jefferson,
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